Marcus had heard the term 501(c)(3) repeatedly, as he investigated the possibility of starting his own charity. He was beginning to suspect that he needed “a 501(c)(3),” as at least one acquaintance had already told him. But what was “a 501(c)(3)”? It sounded like some strange potion, elixir, or beast, perhaps even a supernatural entity with magic powers to unleash to help him achieve his charitable mission. Of course, he already knew better than that. But he still didn’t really know what “a 501(c)(3)” was, and he suspected that a few of the people who had bandied that term about with him didn’t know what a 501(c)(3) was, either.

Code

The term 501(c)(3) refers to the section of the Internal Revenue Code under which charitable organizations can qualify for tax-exempt status. It is admittedly a bit strange that people, not just lawyers but lay individuals, know charitable organizations by the code section number under which the IRS recognizes them. What, are we all now lawyers? Can’t we just call them what they are, which is tax-exempt charitable organizations? Yet that’s a mouthful, which is probably why so many people use 501(c)(3) as a substitute. Using 501(c)(3) to describe the charitable organization also ensures that we’re talking specifically about a charity that is exempt from federal income taxation, which is what donors, private foundations, and government grant programs generally want to know when dealing with charities. So, there you have it: a 501(c)(3) is a charitable organization that the IRS has formally recognized as exempt from federal income taxes.

Organization

Yet that definition just given, like most definitions, is somewhat circular. Of course, a 501(c)(3) is a charitable organization. But what is a charitable organization? When the IRS acknowledges that an applicant meets the requirements of the Internal Revenue Code’s Section 501(c)(3) for tax-exempt status, the IRS isn’t recognizing an individual or a loose association of individuals. The IRS isn’t recognizing a name, program, or activity. The IRS is instead recognizing a specific corporate entity, most often a nonprofit corporation incorporated under the laws of a specific state. Thus, a 501(c)(3) is usually a nonprofit corporation formed to carry out a purpose that the IRS recognizes as charitable. To qualify for a 501(c)(3), you’ll thus need to form a nonprofit corporation under state law and then obtain from the IRS an employer identification number (EIN) for that nonprofit corporation, so that the IRS has a legal entity to recognize as tax exempt. 

Taxation

But saying that a 501(c)(3) is a nonprofit corporation that the IRS has recognized as tax exempt still doesn’t fully answer what a 501(c)(3) is. You should also know the nature of tax exemption, to understand the purpose and value of the 501(c)(3) designation. When a charitable organization qualifies under Section 501(c)(3) as tax exempt, the qualification relieves it from paying federal income tax on its net receipts. Congress taxes business corporations, including nonprofit corporations that have not qualified for tax exemption, on their net earnings. Congress does not tax qualified charitable organizations on their net receipts. Other tax authorities beyond the IRS may also use IRS 501(c)(3) recognition to exempt your organization from their tax obligations. Your organization’s 501(c)(3) status probably relieves your organization from paying state income taxes and may relieve your organization from paying real property taxes on its facility. It may not relieve your organization from paying sales taxes or employment taxes. Read more on taxation in subsequent chapters.

Language

You might have noticed, from the prior paragraphs, small differences in the language that charitable organizations use to describe their receipts and net receipts, when compared to business organizations. The language of charities differs in important respects from the language of the business world, for good reasons. Pay attention to those language differences when communicating about your charitable organization and its activities. For instance, 501(c)(3) charitable organizations tend to describe the donations and gifts they receive, and even the money they receive from the sale of goods and services, as receipts more so than revenue, and their receipts net of expenses they incur as net receipts rather than profit. Business corporations profit and pay taxes on profit. Charitable organizations may retain net receipts over expenses but do not pay income taxes on those net receipts. Get it? The financial transactions are basically the same. So is the accounting. But the terminology differs to distinguish the fundamentally different purposes of businesses and charities. Businesses seek profit. Charities pursue charitable purposes and missions.

Definition

To really get into the details about what is a 501(c)(3), take a brief look at the actual Internal Revenue Code section. Section 501(c)(3) offers tax exemption to corporations “organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes,” with certain conditions. A later chapter addresses the limiting conditions. Here, though, look at the list of qualifying tax-exempt corporations. The list begins with religious organizations, like churches and synagogues, and ends with educational corporations, referring to private schools. (Public schools are government entities, already tax exempt.) So, yes, churches and private schools can and do qualify as 501(c)(3) organizations. Charitable organizations are next in the tax-exempt list after religious organizations. Case law has held that everything else in the list, including scientific, safety-testing, and literary corporations, falls under the charitable rubric. That’s why the IRS and others call 501(c)(3) corporations charitable organizations. Charitable covers everything else in the list.

Charity

Although Congress gave the IRS a tax-exempt list of charitable organizations, Congress did not give the IRS a clear, affirmative definition for what constitutes or defines charitable. Instead, Congress gave the IRS some conditions for what would disqualify an organization from claiming charitable tax-exempt status, discussed in a later chapter. Congress also gave the IRS, and the IRS developed or elaborated on its own, some indirect tests for what indicates charitable status. Congress had good reason not to give a specific definition to the term charitable. Anyone writing law knows that the moment you define a term with specifics, other specifics pop up that require or warrant redefinition. The finer a point you try to put on things, the worse it gets. If, for instance, Congress had said that charitable means soup kitchens, then someone would have immediately asked but what about homeless shelters? And on, it would have gone. So instead, Congress offered and the IRS developed indirect tests and limiting conditions for charitable status.

Contributions

So, now you need to know a bit about the primary test the IRS uses to define a charitable organization, because Congress didn’t give anyone a definition. Let’s try not to get too far into the details, but the IRS uses a public-support test to qualify charitable organizations for the preferred, public-charity form of 501(c)(3) status. Private foundations are also 501(c)(3) organizations but face much stricter reporting requirements and some taxes that public charities do not face. The public-support test asks whether the public charity attracts, or if it has not yet begun operations whether it expects to attract, public contributions. Will the charity’s declared charitable purpose move the hearts, minds, and hands of donors to give to the organization? If the organization’s representative believes so, then the representative will so indicate on the organization’s application for tax-exempt status. The IRS can later look at the organization’s operations to determine whether the assertion proved accurate or whether the IRS should reconsider and revoke the organization’s preferred tax-exempt public-charity status.

Hearts

The public-support test makes sense for qualifying public charities. A public charity is still a private nonprofit corporation. The public descriptor simply refers to the public-support test, that the charity’s purpose moves the hearts of donors sufficiently to attract their donations. The public-support test is pretty technical but basically requires that at least one-third of the charity’s donations come from donors who give less than 2% of the organization’s total receipts. What that means is that a public charity must have a decent number of small donors, even if the other two-thirds of their total receipts comes from big donors or revenue from charitable sales of goods and services. And again, to have a good number of small donors, your public charity will need a purpose that moves those small donors. If your charity gets those small donors to give, the IRS accepts that your purpose was sufficiently charitable. In other words, small money donations prove the charitable purpose. People with small amounts of extra money don’t generally give it to commercial entities, crooks, or swindlers.

Foundations

The prior discussion may be a lot for you to consider. Yet permit a couple of clarifications about the public-support test. Your organization only has to meet the public-support test to qualify as the preferred public charity. Otherwise, if your organization gains more than two-thirds of its support from a small number of donors giving larger percentages than 2%, and from sales revenue, you can still have a 501(c)(3) organization. It will just be a private foundation rather than a public charity. Two features distinguish private foundations from public charities. Private foundations have large donors, not many small donors. Wealthy families and rich corporations establish private foundations. The other feature of private foundations is that they tend to give money (grants) to public charities to conduct charitable programs, rather than conduct their own charitable programs. In short, if you have a dream to help people by providing charitable service, your dream is for a public charity, not a private foundation.

Sales

The other clarification you may need about the above discussion is that charitable organizations, including the preferred public charities, may generate revenue from the sale of goods and services, without affecting their tax-exempt status. Many public charities charge something for their goods and services, presumably a discounted, below-market price, but still something. Indeed, a charitable principle is to allow the individuals you help to carry whatever share of the charitable burden they can, to encourage self-responsibility and respect for the charity, while enabling the charity to help others. Soup kitchens, for instance, often charge a small meal fee to their homeless or otherwise destitute patrons, even if they also waive the fee in appropriate cases. Your charitable organization may likewise do so, even raising up to two-thirds of its total support from sales, and still qualify as a public charity under the one-third public-support test.

Alternatives

The public-support test is not the only way for you to qualify your charitable organization as tax exempt, under the preferred public-charity status. The IRS offers a second,  facts-and-circumstances test. In point of fact, many organizations that are plainly charitable in nature do not attract one-third of their total receipts from small donors. They instead operate without much donor support or with only a few donors providing support, while generating enough sales revenue to keep the charity’s doors open. A soup kitchen could again be a good example. Some soup kitchens operate with mostly government grant support, grocer, food service, or restaurant donations of food, and sales revenue, without qualifying as a public charity under the public-support test. Yet a soup kitchen is obviously charitable when, under its peculiar facts and circumstances, it is serving a homeless or desperately under-privileged population, using mostly volunteer labor, in a low-rent or donated facility, while trying to attract more small public donations. The facts-and-circumstances test lets a charitable organization qualify for the preferred public-charity status, if receiving at least 10% of its total receipts from public donations while working to increase that percentage above the usual one-third public-support minimum.

Simplify

If you have even a basic sense, now, of what a 501(c)(3) is, then you’re ahead of the game. Many founders of 501(c)(3) organizations have only a basic sense of what the Internal Revenue Code actually requires in the way of meeting tests and definitions. They may know a lot less than what this chapter outlines. That doesn’t mean that they are ignoring their legal obligations or trying to cheat the IRS. Instead, they may be relying on customs that other charitable organizations typically follow, keeping them within a safe harbor for qualifying actions. They may also have an accountant helping them with payroll, a board member who was once a public charity leader, and others with relevant experience helping them. Don’t overthink it. Get the help you need, when you need it. But now you should know enough to proceed with forming your own 501(c)(3) organization.

Key Points

• Internal Revenue Code Section 501(c)(3) defines a public charity.

• Your 501(c)(3) organization needs to incorporate as a nonprofit.

• Qualifying as a 501(c)(3) relieves federal income tax obligations.

• The IRS applies a public-support test to qualify 501(c)(3) organizations.

• Meeting the public-support test requires many small donations.

• A 501(c)(3) public charity may generate substantial sales revenue.

• Get knowledgeable advice to answer questions on 501(c)(3) status.

Read Chapter 5.